MarketWatch | Fund that almost tripled the S&P 500’s gain last year is now big on health-care stocks

The Highland Small Cap Equity Fund made a killing on energy stocks in 2016, generating a 32% return for investors

Michael Gregory, whose energy-stock picks helped the Highland Small Cap Equity Fund almost triple the return of the S&P 500 Index last year, now says the out-of-favor health-care sector could stage a “tremendous rebound” in 2017.

The mutual fund’s Class A shares HSZAX, -0.28% returned 31.6% in 2016, compared with returns of 12% for the large-cap S&P 500 SPX, -0.18% and 21.3% for the small-cap Russell 2000 Index RUT, -0.36%

Gregory is chief investment officer of Highland Alternative Investors, a unit of Highland Capital Management, which is based in Dallas and manages about $15.4 billion. He oversees the small-cap stock fund with James Dondero, the president and co-founder of Highland Capital Management. The fund itself is small, with about $55 million in assets.

A great year

Gregory said Highland’s “credit competency” helped it make lucrative investments in pipeline partnerships in early 2016, when oil prices bottomed. Those investments contributed about half of the fund’s total return last year.

Gregory said none of the selected partnerships cut dividends after the fund purchased shares.

“What was interesting to us was that MLPs [master limited partnerships] provided us with high-single-digit or low-double-digit [dividend] yields,” he said. “The cash flow is predicated on volume rather than the price of crude.”

Gregory and Dondero also focused on MLPs with solid “sponsors,” which are the main pipeline customers for oil producers.

Two MLP winners in 2016 were Energy Transfer Equity LP ETE, -2.37% and SemGroup Corp. SEMG, -2.63% each of which gained nearly 100% for the fund last year. But Gregory said the fund had taken “about two-thirds of the chips off the table” for each position.

“So we have done a good job harvesting our gains and capturing our profit and sizing down to a position we think is appropriate,” Gregory said. He said the price of crude oil “can head into the $60s near-term.” West Texas crude oil for March deliveryCLH7, -1.23% closed at $52.75 on Jan. 25.

Six stock picks

The only sector of the S&P 1500 Composite Index to post a decline last year was health care, which had a return of minus 2.1%. Gregory pointed to the great “dispersion” between the performance of the energy and health-care sectors, and said “we might see a tremendous rebound” for health care in 2017.

Health care

When naming two health-care stocks he likes today, Gregory addressed the “public health epidemic” of opioid addiction in the U.S., and said “the insurance companies are starting to do something about it” by fast-tracking their approval process for new, less-addictive pain relievers.

One example of a company with a new approach to pain relief is Collegium Pharmaceutical Inc. COLL, +4.74% which has developed Xtampza ER, an oxycodone medication designed to reduce the chances of addiction or abuse through the combination of oxycodone “with fatty acid and waxes to form small spherical beads (microspheres) that are filled into a capsule.”

Those extra ingredients are meant to make it difficult for someone trying to abuse the medication to concentrate doses by “rigorous physical and chemical manipulation such as breaking, crushing, chewing and dissolving.”

Gregory sees the potential for explosive sales growth for Collegium, as the company is “just shy of 200 million Americans who can access this drug currently.”

Another company with an interesting new pain-relief product is Pacira Pharmaceuticals Inc. PCRX, -1.20% which makes Exparel, a non-opioid pain reliever used for soft-tissue surgeries and orthopedic procedures. The medication is injected during surgery.

“It is doing over $200 million in sales currently,” Gregory said. He expects one of the “catalysts” for Exparel this year to include the approval of the drug for use in knee-replacement surgery.

Real estate

Gregory said he was focused on multifamily real estate investment trusts (REITs) and has looked at “a concept we’ve proven ourselves,” through NexPoint Residential Trust Inc. NXRT, -1.43% which Highland manages but does not hold within the Highland Small Cap Equity Fund. That concept is acquiring multifamily properties and improving them, justifying higher rents. NexPoint’s stock returned 79.5% last year.

The first REIT holding that Gregory mentioned in an interview was Independence Realty Trust Inc. IRT, -0.22% a multifamily REIT he said was “very similar in strategy” to NexPoint.

The other REIT Gregory said he favored was Jernigan Capital Inc. JCAP, -0.83% which invests in self-storage facilities. “Think of the demographic boom going on in cities like Dallas, San Antonio, Nashville and Austin. When people move, they need to put their things somewhere, and … when they do, they never leave. So we get a mid- to high-single-digit dividend yield [of 6.75%], with increasing operating income,” he said.

Energy

Gregory named two pipeline operators, Western Gas Equity Partners LPWGP, +0.15% which has a dividend yield of 4.08% and has what Gregory calls a “very strong sponsor” in Anadarko Petroleum Corp. APC, -1.47% ; and Tesoro Logistics LPTLLP, -0.02% which has a dividend yield of 6.36%, and is sponsored by Tesoro Corp.TSO, +1.86%

Gregory said it’s important to make sure an MPL’s sponsor company is well-capitalized, “with activity across a diverse book of basins.”

“We think MLPs as a class will appreciate 15% to 20% this year, while the MLPs we own can far exceed that return,” he added.

History, long-term performance and expenses

Highland Alternative Investors acquired the Small Cap Equity Fund from GE Asset Management in 2010. A series of subadvisers helped manage the fund until July 2015, when Gregory and Dondero took over. The fund has three share classes, and it’s important to consider sales charges and expenses carefully by looking at the prospectus for this or any other mutual fund:

Morningstar rates the Highland Small Cap Equity Fund four stars out of five, for performance, and considers its expenses “above average.”

Here are total return figures for the fund’s three share classes, excluding sales charges:

It’s pretty obvious when looking at the performance of the Russell 2000 IndexRUT, -0.39% that 2016 was a big year for small-cap stocks.

The Highland Small Cap Equity Fund’s Class A shares HSZAX, -0.28% have an upfront sales charge of 5.75% and total annual expenses of 1.60% of assets. Class CHSZCX, -0.39% shares have no upfront sales charge, carry a 1% deferred sales charge for shares sold within six months of purchase, and have total annual expenses of 2.35%. Class Y HSZYX, -0.26% shares have no sales charge, and annual expenses of 1.35%, but are available only to institutional investors. All of those expense figures reflect the waiver of 0.42% of annual expenses, which will continue at least until Jan. 31, 2018.